Tuesday, September 30, 2014

According to Case-Shiller, housing prices in 20 large metropolitan areas fell, on average, in the months of May, June, and July, following over two years of steady and impressive gains (the index is calculated monthly using a three-month moving average and published with a two month lag). I doubt this is the beginning of another major downturn in prices—it's much more likely to be just a "pause that refreshes." That's because mortgage rates remain very affordable, the economy is still growing, personal incomes are still growing, and the Fed hasn't tightened monetary policy. (see charts below)

Case-Shiller also reports a series of housing prices in 10 major metropolitan areas which extends back to 1987. Here we see that real home prices have only increased at an annualized pace of 1.7% in the past 27 years, and prices today, in real terms, are about the same as they were in 2002. Real incomes, in contrast, are up at a 2.7% annualized pace over the same period. Couple that with the fact that mortgage rates today are 4-4.5%, whereas they were twice as high in 1987, and you find that housing prices are much more affordable these days.

It's a good thing that the housing market has cooled off somewhat, since that will give folks like my daughter and her husband a chance to search for and bid on a home in a less-frenetic atmosphere. They were beginning to think that they had missed the affordable-housing train.

The first of the above two charts compares the increase in housing prices since 1987 with the increased cost of renting a home ("homeowner's equivalent rent," which gets a weighting of about 25% in the Consumer Price Index). Home prices have only slightly outpaced the increase in rents in the past quarter-century. The second chart shows how the rise in home prices tends to feed into the calculation of the CPI with a lag of about 18 months. The recent pause and decline in prices is likely going to moderate the rise of the CPI over the next year or so.

Thursday, September 25, 2014

The Argentine economy is in recession, the central bank's forex reserves are dangerously low, having fallen by almost half in the past few years, and inflation is raging. Worst of all, the government is doing everything wrong. Its peronist/populist president is completely out of touch with how economies work, and its economy minister is a young, starry-eyed socialist and former economics professor who wouldn't be able to get a teaching job in the U.S. to save his life.

Under Argentina's pegged exchange rate system, a loss of reserves is an unambiguous sign of capital flight: more money wants to leave the country than wants to come in. To enforce its currency peg, the central bank must sell dollars to accommodate those who want out. With reserves now critically low, the central bank has taken the further (and inevitable) step of rationing access to the official exchange rate. This means that those who want out are forced to use the parallel—or "blue"— currency market.

The problem started about four years ago. Once the government started rationing access to the official peso rate, a parallel, or black market for dollars soon developed and the official and "blue" rates started to diverge. The current gap between the blue rate and the official rate is now more than 70%, a sure sign that confidence in the peso is extremely weak. As the chart above shows, a similar gap opened up in the second quarter of last year, and it preceded a major devaluation of the official peso by some 8 months. Another official devaluation is almost certain, and with it should come even higher inflation and a further loss of confidence. Unfortunately, Argentina's leadership does not understand what is happening and refuses to take the appropriate corrective action, so hope for improvement is nil.

Fixing things would, among other things, require a substantial tightening of monetary policy. For years, Argentina's central bank has expanded its balance sheet in classic "money printing" fashion, by lending significant sums of money, mostly in the form of newly-printed currency, to the government, in exchange for a flimsy promise that it will be repaid. Argentina is literally a proving ground for the theory that when too much money (actual peso currency) chases a limited amount of goods, the result is inflation. As the chart above shows, the amount of pesos in circulation has increased at a 30% annualized rate for the past five years, even as the demand to hold pesos (people would much rather have dollars) has plunged. A rapidly rising money supply and a declining demand for that money is nothing less than a perfect inflation storm.

Fixing things would also require a return to free market policies, a commitment to a stable peso (e.g., something like dollarization), free capital flows, and a recognition that past debts must be honored. Unfortunately, the current government is loathe to even consider such measures, even though they could produce powerfully positive results.

Watching Argentina implode is like watching a slow-motion train wreck. It's inevitable and terribly destructive, and all for no purpose except to enrich the ruling class.

Venezuela is in much worse shape than Argentina, and Brazil is in a recession, and the Brazilian real is once again in decline. Even Chile, which had been doing so well for so long, is succumbing to bad policy decisions, with the result that its economy is slowing, inflation is rising, and the Chilean peso is falling. South America is in a world of hurt, with no lifelines on the horizon.

A week ago I argued that there was "no need to fear Fed tightening," because both bond yields and the Fed were reacting to declining risk aversion and an improving economic outlook. My point: higher yields are not a threat to growth, they are a by-product of an improved growth outlook.

This week I change the focus slightly, and look at the behavior of Treasury yields during business cycles. What has happened this year is very typical of what happens as the business cycle matures. The yield curve has flattened somewhat, but it is nowhere near the flatness that typically presages a recession.

The chart above shows the history of 2- and 10-yr Treasury yields. The long secular decline in yields since the early 1980s has been driven by declining inflation, declining inflation expectations, and, more recently, by slower growth expectations.

2-yr yields are equivalent to what the market thinks short-term interest rates will average over the next 2 years. Rising 2-yr yields are thus a sign that the market is ratcheting upwards its expectations for Fed tightening, because the Fed has a very powerful influence on short-term interest rates.

10-yr yields, on the other hand, are largely driven by the market's expectations for economic growth and inflation. The Fed can influence these expectations to some extent, but not by much. The chart shows that even though the Fed purchased trillions worth of notes and bonds in three rounds of Quantitative Easing, 10-yr yields rose during each episode of Quantitative Easing. Yields rose because the market perceived that the Fed's bond purchases were correctly addressing a problem and thus improving the outlook for growth. Yields fell after QE1 and QE2 because the market realized that the Fed had not done enough to address the world's demand for safe assets, and this threatened the outlook for growth. We now know that QE3 is virtually finished, but yields have only declined marginally, which in turn suggests that this time the Fed has done enough.

Some have suggested that the recent decline in 10-yr yields and the rise of 2-yr yields might be the bond market's way of telling us that a tightening of monetary policy next year could prove debilitating to the economy. But as the chart above shows, the current spread between 2- and 10-yr Treasuries is still quite wide—the yield curve is still plenty steep. The economy has flourished for years with a yield curve as steep as today's. It's only when the curve gets flat or inverted that the economy is approaching trouble.

The chart above shows that every recession since 1960 has been preceded by a severe tightening of monetary policy. Very tight money shows up in high and rising real short-term interest rates (the blue line) and a flattening or inversion of the yield curve (red line). Today both of these indicators remain firmly planted in "easy money" territory.

Conclusion: the bond market is not displaying any concerns about what might happen to the economy when the Fed starts raising interest rates next year.

After being relatively flat for most of 2013, capital goods orders—a good proxy for business investment—have rebounded strongly this year. Today we learned that August orders exceeded expectations (+0.6% vs. +0.4%), and the decline in July orders was revised down from -0.5% to just -0.2%. On a year over year basis, orders rose 7.5% through August.

This series suffers from a mysteriously deficient seasonal adjustment which can be largely corrected by looking at the 3-mo. moving average, which I've shown in the chart above. Using the smoothed series, we find that the 6-mo. annualized gain in orders is a very impressive 14.5%.

Inflation-adjusted orders are still about 15% below their 2000 high, but they are closing in on their pre-recession high. Thus, while the level of orders is still disappointing, the change on the margin is quite encouraging, and that's what matters the most to markets and the economy.

Business confidence has picked up this year, with the result that today's new investment in capital goods should lead to increased worker productivity and somewhat faster real growth in the months and years to come.

We see the same picture in Commercial & Industrial Loans, which are a good proxy for bank lending to small and medium-sized businesses. As the chart above shows, the growth rate of C&I Loans picked up starting last January. Since mid-January, loans are up at a 14% annualized rate. This reflects a significant improvement in confidence on the part of banks and businesses (banks more willing to lend, businesses more willing to borrow).

Tuesday, September 23, 2014

Here is a collection of charts that feature real, physical measures of the growth of the economy. They are all consistent with an economy that continues to expand.

Truck Tonnage. This data is collected by the American Trucking Association. It measures total for-hire truck tonnage, and is seasonally adjusted. Truck tonnage in August reached a new all-time high, and is up 4.5% over the past year. The top chart shows the index from 2007 on, while the bottom chart shows the index from 1973 on, and compares it to the inflation-adjusted S&P 500 index. The point of this latter chart is to show that the rise in the real value of equities is proportional to the increased amount of goods hauled around the country. The equity market, in other words, is not unhinged from reality or caught up in a bubble. I note that the chart did suggest equities were in a bubble in the late 1990s, while equities appeared to be extremely undervalued in the Great Recession.

Chemical Activity. This data is put together by the American Chemistry Council, and is derived from a composite index of chemical industry activity. The top chart shows the history of the index, the bottom chart zooms in on the last seven years of the index, and the middle chart compares the year over year growth of the index to real GDP growth. Although the growth of the index has slowed a bit in recent months, it is still consistent with an economy that is growing 2-3% per year.

Architecture Billings. The American Institute of Architects every month asks its members whether their billings for work on the board have increased, decreased, or stayed the same. Last August marked the most number of positive responses since the Great Recession. Even on a 6-month moving average basis, the index shows that the nation's architectural firms are experiencing increased demand for their services, a good indication that commercial construction activity will be expanding in the future.

Crude Oil Production. Thanks to fracking technology, U.S. crude oil production has grown by leaps and bounds—up 54% in the past three years, for an annualized gain of an astounding 15% per year. It's hard to underestimate how much the ripple effects of such an increase are affecting overall economic activity.

Intermodal Rail Traffic. The American Association of Railroads reports that rail shipments of freight containers in the year ending September 12th rose 6.5% from the previous annual period, and registered a new all-time high.

As the WSJ article notes, it's still questionable whether the administration has the authority to block inversions via executive order. But in the meantime, this is likely to add up to a disincentive to invest in the U.S. economy. Capital only goes where it is welcome and treated nicely. One essential ingredient for a strong economy is to ensure the owners of capital that they are free to come and go as they wish. Trying to keep company headquarters here by force will only work to keep headquarters from coming here in the first place.

My years living in Argentina taught me firsthand that the best way for a country to stimulate capital flight is to try to prevent capital from leaving. It's very sad to see the U.S. emulating the proven-to-fail mistakes of the Argentine government.

This probably won't keep the dollar from appreciating further, but it will add to the headwinds that are keeping the U.S. economy from realizing its full potential.

The U.S. dollar has made some impressive gains of late, brightening the outlook in general with the hope that economic and political fundamentals continue to improve in the years to come. I've borrowed the title of this post from my good friends Larry Kudlow and Steve Moore, and I think this post makes a nice complement to their recent column in National Review Online.

Against a trade-weighted basket of major currencies, the U.S. dollar has risen over 15% from its all-time low of three years ago, and over one-third of that increase has come in the past three months (see chart above).

It's been an impressive rally of late, but as the chart above shows, from a long-term perspective the dollar is still relatively weak, whether measured against a trade-weighted, inflation-adjusted basket of major currencies or against a similar basket of more than 100 currencies (see chart above). Relative to its all-time high of May, 1985, when the economy was booming and the Fed was fighting inflation with sky-high interest rates, the dollar today is almost 30% weaker. Relative to the early 2000s, when the economy and equity markets were booming and the Fed was fighting the specter of rising inflation, the dollar today is about 20% weaker.

The following charts focus on the dollar's strength and weakness relative to five major currencies, by comparing their current (spot) value to my calculation of their Purchasing Power Parity value. PPP theory holds that, over time, currencies move vis a vis others in a way that reflects changes in relative prices between between countries. Currencies that depreciate against others typically have higher inflation rates, and currencies that appreciate have lower inflation. For each currency I've picked a base year in which I thought that prices were in rough equilibrium, then adjusted that value over time for changes in relative inflation rates. The current PPP value of each currency is therefore approximately equal to the exchange rate that would produce roughly equal prices for a given basket of goods and services in each country.

By my calculations, the current PPP value of the Euro vis a vis the dollar is about 1.16 dollars per Euro. Since the Euro is currently trading at 1.29, that implies that a U.S. tourist visiting the Eurozone today would find that goods and services there cost about 10% more than in the U.S. on average (1.29/1.16 = 1.11).

As for Sterling, my calculations suggest that goods and services in the U.K. today cost about 25% more than they do in the U.S. In other words, the pound is about 25% "overvalued" relative to the dollar. The fact that the green line has been sloping down for the past several years tells us that U.K. inflation has been higher than U.S. inflation, and that over time the pound is therefore likely to fall relative to the dollar, all other things being equal.

The yen has experienced a rather dramatic weakening over the past three years, falling from a high of 75 to almost 109, for a loss of over 30% against the dollar. Big currency losses like this are rarely good news, but in this case the big drop in the yen has coincided with huge gains in the Japanese equity market, as the second of the above charts shows. I think that's because the yen had been so strong for so long against almost every currency on the planet that it had created deflationary pressures which were suffocating the economy. The yen's relentless appreciation over the previous 40 years made life very difficult for Japanese industry, for example, since they had to continually cut their costs to remain competitive with overseas manufactures. Now that the yen is closing in on its PPP value relative to the dollar, and the Abe administration is pursuing more growth-oriented fiscal policies, it's become very good news for the Japanese economy and for the world.

As the first of the above two charts shows, big changes in the dollar's value tend to go hand in hand with big (and inverse) changes in the prices of commodities. Commodities peaked in 2011 about the same time the dollar hit its all-time low; a rising dollar since then has coincided with a return of weaker commodity prices. Since the Australian economy is heavily dependent on commodity exports, the Aussie dollar has tended to move with commodity prices. It too peaked against the dollar in 2011, and since then it has dropped almost 20% relative to the U.S. dollar. By my calculations, the Aussie dollar is still about 40% "overvalued" against the U.S. dollar, making Australia a rather expensive vacation destination for U.S. tourists. (And by the same logic, the U.S. offers very inexpensive vacations for Australian tourists.)

The story is quite similar for the Canadian dollar, since Canada is also dependent on commodities, although not as much as Australia. I figure the loonie is still almost 20% "overvalued" against the U.S. dollar. As the chart above shows, Canadian inflation has been almost identical to U.S. inflation over the past 20 years, which makes it likely that eventually the loonie will weaken further against the dollar.

Why was the dollar so weak three years ago? The list of possible causes is long, but I think the important ones are 1) fears that the Fed's QE efforts would debase the dollar and lead to higher inflation; 2) fears that trillion-dollar federal budget deficits would prove to be the norm and that in turn would lead to a significant rise in U.S. tax burdens; and 3) fears that an onerous increase in regulatory burdens under Obamacare and Dodd-Frank would weigh on the economy; and 4) fears that the U.S. economy was vulnerable to a double-dip recession.

We've still got lots of problems to deal with (and the dollar is still weak), but we now know that the Fed hasn't (yet) made a big inflation mistake, and is on the verge of ending QE and beginning to normalize short-term interest rates. We also know that the federal budget deficit has fallen by two-thirds and is currently quite manageable. Moreover, the debate over entitlement spending, which holds the key to the long-run budget outlook, is now centered around when and by how much spending can be cut, not whether. The ongoing failure of Obamacare and the long list of bureaucratic scandals in recent years have convinced a majority of the people that we suffer from too much, not too little government. Too much government killed Greece, and it's killing Venezuela and Argentina as we speak. Finally, the U.S economy has managed to grow by a relatively steady 2% pace for the past five years, and has been able to grow despite pronounced weakness in the Eurozone and a significant slowdown in the Chinese economy.

In short, things have turned out much better than the market feared.

Looking ahead, it's now pretty clear that the Fed is going to pursue tighter monetary policy than the ECB, the BoE, and the BoJ. Interest rate differentials are moving in favor of the dollar (i.e., U.S. short-term rates are rising relative to overseas rates) in anticipation of this, and that has also helped boost the dollar, as the chart above shows.

So even though the U.S. economy is saddled with a very uncompetitive tax system, a hugely burdensome regulatory environment, and an abysmally low labor force participation rate, it's doing better than most other countries.

In short, things haven't turned out nearly as bad as the market feared.

Investment implications. With the outlook improving on the margin and the dollar rising on the margin, U.S. investments look attractive relative to non dollar investments. Commodity prices are likely to weaken further if the dollar continues to strengthen. This is unlikely to be bad news for emerging market economies, however, because the dollar will be strengthening, and interest rates will be rising, as the outlook for the U.S. economy improves. A stronger dollar that results from overt and aggressive Fed tightening can be very bad news for emerging markets, since it presages a sharp slowdown in the U.S. economy—that was the case in the early 2000s. Every recession in the past 50 years has followed a period of very tight monetary policy, as evidenced by high real interest rates and a flat or inverted yield curve. We're years away from that.

As the PPP charts above suggest, the currencies with the most to lose potentially against the dollar are the Aussie dollar, the Canadian dollar, and Sterling.

A stronger dollar would most likely lead to weaker commodity prices, especially so in the case of gold. As the chart above suggests, gold prices "overshot" commodity prices in the wild and wooly days following the near-collapse of global financial markets during the depths of the Great Recession, and the onset of the Fed's unprecedented expansion of its balance sheet. Fortunately, the world has emerged intact, the dollar has not been debased, and inflation remains low. Without a great deal of fear to sustain it, gold prices are unlikely to sustain their still-lofty levels. In the absence of any new fears, gold is likely to converge back down to commodity prices.

I'm pleased to note that in my predictions for 2014 I correctly thought that the dollar would strengthen this year, and that gold and commodities were unattractive investments. (Check out my other predictions, most of which still appear to be correct.)

Thursday, September 18, 2014

U.S. households continued to enjoy strong gains in net worth in the second quarter of this year, according to just-released data by the Federal Reserve. Thanks mainly to gains in financial assets, net worth rose to a new high in nominal and real terms; on a real per capita basis, net worth is within inches of an all-time high. In the 12 months ending June, 2014, household net worth increased by 10%, or almost $8 trillion. (For purposes of comparison, consider that the market cap of global equities rose by over $11 trillion in the same period.)

Household debt totaled just under $14 trillion in the second quarter, for a net increase of zero over the past 7 years; in real terms that represents a reduction of over 10%, and that counts as some serious deleveraging. The ratio of household debt to net worth has now fallen from a high of 25% in the first quarter of 2008 to 17%—a reduction in leverage of about one-third.

Since their recession lows, real estate valuations have increased by about $2.2 trillion, while the value of financial asset holdings have increased by more than $21 trillion.

Real household net worth now stands at a new high, and is on track with its long-term annualized growth rate of 3.6%.

On a real, per capita basis, net worth in the second quarter was slightly less than its pre-recession high. Annualized gains over the long haul have been 2.4%, reflecting population growth of a little more than 1% a year. The average family of four now has a net worth of just over $1 million.

A few trillion here, a few trillion there, and you have the makings of some serious gains in prosperity. Since 1950, real per capita net worth has more than quadrupled, and new highs are just about inevitable.

Does it matter that the rich control a disproportionate share of total net worth? Not as much as you might think. The vast bulk of the wealth of the rich is tied up in real estate (mostly commercial) and ownership stakes in successful businesses. Those holdings are valuable only because they provide much-needed and much-desired goods and services to all of us. Without their wealth we would all be much less prosperous.

Wednesday, September 17, 2014

The August CPI report showed inflation to be a bit lower than expected (-0.2% vs. 0.0%), thanks mainly to falling energy prices. As the chart above shows, both total and core consumer price inflation are running a little under 2% per year, which is largely unremarkable. The bond market, however, is making some interesting adjustments these days: TIPS prices have fallen significantly, as inflation fears subside and the market adjusts to a somewhat improved outlook for economic growth.

The above graph shows what I think are the two most important variables to watch these days: the real yield on 5-yr TIPS and the price of gold. (The blue line is the inverse of the real yield on 5-yr TIPS, so it is a good proxy for their price.) The prices of both gold and TIPS have been under downward pressure in the past few years, with pressure intensifying of late: real yields on 5-yr TIPS have jumped by some 45 bps in just the last month, while gold prices have fallen over 7% in the past two months.

As detailed here in a post one year ago, I think this reflects an important decline in the market's demand for safe assets, which is equivalent to an increase in the market's general confidence in the future, and equivalent to a decline in risk aversion. This is very important because the whole purpose of the Fed's Quantitative Easing programs, as I see it, has been to satisfy the world's demand for safe assets, not to stimulate the economy. In other words, QE was a response to the tremendous risk aversion which arose in the wake of the Great Recession. Risk aversion is now beginning to fade, so it is appropriate that the Fed should end its QE program. The FOMC announcement today confirms that QE3 will end next month, and the Fed will begin increasing short-term interest rates next year by raising the interest rate it pays on reserves.

The rise in real yields on TIPS is also a sign that the market's outlook for economic growth is improving. As the chart above shows, real yields tend to track the economy's growth potential over the years, which makes a lot of sense. TIPS are unique because they offer a guaranteed real rate of return. That risk-free real return should be somewhat less than the expected real growth of the economy, since that is fundamentally uncertain. But real yields have been unusually low for the past few years (e.g., real yields have been -0.5%, whereas real economic growth has been a little over 2%), which I've taken to be a sign that the market was very pessimistic about the outlook for growth. That's now beginning to change for the better, as real yields move higher. It's not that the market has turned optimistic, however; it's more accurate to say that the market now has become less pessimistic.

The two charts above show the nominal and real yields on 5- and 10-yr TIPS, and the difference between those yields, which is the market's expected average rate of inflation over the next 5 and 10 years. The current expected rate of inflation over the next 5 years is about 1.8% per year, and the expected rate of inflation over the next 10 years is about 2.1%. This implies that the expected rate of inflation from 2020 to 2024 is about 2.5% (otherwise known as the 5-yr, 5-yr forward expected rate of inflation). This is not particularly scary, but it does suggest that the Fed can't afford to wait too long before tightening policy, since long-term inflation expectations are somewhat higher than the 2% the Fed now considers to be optimal.

The chart above shows Bloomberg's calculation of the 5-yr, 5-yr forward expected rate of inflation. Expectations today are almost identical to what they have been on average over the past seven years. No sign of deflation, and no sign of unpleasantly high inflation either—almost a goldilocks outlook. But with the outlook for the economy improving on the margin, it doesn't make sense for the Fed to continue its ultra-accommodative monetary posture much longer. Given the muted reaction to today's FOMC's announcement that QE3 is almost finished and higher short-term rates are coming next year, it appears the market agrees.

This is all good. The Fed and the bond market are responding appropriately to declining risk aversion and a somewhat improved economic outlook. There is no reason to fear the end of QE or the beginning of higher short-term interest rates.

Tuesday, September 16, 2014

One unique characteristic of the past two decades is the more than 30% decline in the prices of durable goods. Outside of durables, prices of just about everything else have been rising. The decline in durable goods prices began in 1995, which not coincidentally was about the time when China pegged its currency to the dollar (after devaluing it by one third the year before) and launched its export boom. We have China to thank for deflating the prices of most of the durable goods we enjoy these days. That's "good" deflation, since it's not monetary in origin, but rather the result of a huge increase in the productivity of the Chinese economy which has ended up benefiting everyone all over the world.

Personal computers are one very obvious source of durable goods deflation. Since the end of 1997, the BLS calculates that the prices of personal computers and peripherals on average have declined by about 95%—which works out to an annualized decline of 16%. Most of this decline is the result of hedonic pricing, which means that although actual prices haven't declined by anywhere near 95%, if you adjust for the increasing quality, capacity, and capabilities of personal computers and such, then prices have effectively declined by 95%. Since 2010, prices have been falling at an annualized rate of about 8% per year.

The Producer Price Index was flat in August, but up a little more than 2% over the past year. No sign of deflation here.

The dollar's recent 5% rise vis a vis the Euro owes a lot to the fact that the Fed is getting ready to tighten policy, whereas the ECB is trying hard to ease policy further. those expectations are being reflected in German 2-yr yields, now -0.06%, and U.S. 2-yr yields, now 0.53%. The first of the two charts above shows the history of 2-yr yields, while the second shows the spread between the two and the value of the Euro, which have been highly correlated.

The chart above provides convincing evidence for why the Fed is likely to pursue tighter policy than the ECB. U.S. industrial production has been rising strongly for years, whereas industrial production in the Eurozone has been relatively stagnant. The U.S. economy is fundamentally stronger than the Eurozone economy, so short-term U.S. interest rates are very likely to rise relative to their Eurozone counterparts.

The relative outperformance of the U.S. economy has been significant, and is reflected in equity prices. The S&P 500 has outpaced the Euro Stoxx index by 68% over the past five years. U.S. equities now have the added advantage of a strengthening dollar.

As measured by the difference between 10-yr Treasury yields and the level of Core PPI inflation, real yields have been in a declining trend for the past 30 years. This means that, in general, the effective cost of borrowing money for U.S. businesses hasn't been this low since the late 1970s. This is one reason why companies like Apple are borrowing money here to fund dividends and buybacks instead of repatriating overseas profits. Borrowing costs almost nothing, and they avoid double taxation on foreign profits.